EDITORIAL ANALYSIS : Intergenerational equity as tax devolution criterion
Kartavya Desk Staff
Source: The Hindu
• Prelims: Current events of national importance(Federalism, Finance Commission, Cess and Surcharges, NITI Ayog, etc)
• Mains GS Paper II & III: Functions and responsibilities of the union and the states, issues and challenges pertaining to the federal structure etc
ARTICLE HIGHLIGHTS
• The Finance Commission (FC) decides the horizontal distribution formula once every five years.
• The combined government debt-GDP ratio had also shot up close to 90% at the end of 2020-21. Many States show large fiscal imbalances
• Many States show large fiscal imbalances
INSIGHTS ON THE ISSUE
Context
Finance Commission:
The vertical and horizontal dimensions
• The Fourteenth Finance Commission raised the share of States in the divisible pool of central taxes to 42% from 32%. This was revised to 41% when the number of States in India was reduced to 28.
• This was revised to 41% when the number of States in India was reduced to 28.
• During 2020-21 to 2023-24 (BE): The effective share of States in the Centre’s gross tax revenues (GTR) averaged close to 31% It was significantly lower than the corresponding share of nearly 35% during 2015-16 to 2019-20. The increase in the share of cesses and surcharges to 5(eighteen point five)% of the Centre’s GTR during 2020-21 to 2023-24 (BE) from 12.8(twelve point eight)% during 2015-16 to 2019-20.
• It was significantly lower than the corresponding share of nearly 35% during 2015-16 to 2019-20.
• The increase in the share of cesses and surcharges to 5(eighteen point five)% of the Centre’s GTR during 2020-21 to 2023-24 (BE) from 12.8(twelve point eight)% during 2015-16 to 2019-20.
#### Intergenerational fiscal equity:
#### ● Intergenerational equity is the principle of providing equal opportunities and outcomes to every generation.
#### ● Intergenerational equity ensures that the decisions or actions of current generations should not burden the future generation.
#### ● From a public finance point of view, it refers to a situation where every generation pays for the public services it receives and does not burden the future generation through borrowings.
#### Ways to raise revenue:
#### ● Tax: If in a period the tax revenue equals the current expenditure of the government, then the current taxpayers pay for the public services they receive
#### ● Borrowing: If the government finances the current expenditure through borrowings, it means the future generation is going to pay higher taxes to repay this borrowing and interest.
#### ○ Borrowing to meet the current expenditure of the government amounts to intergenerational inequity.
Ricardian Equivalence Theory:
• Whenever the government resorts to borrowing to finance current expenditure households react through higher savings enable the future generation to pay higher taxes as well as keep aggregate demand in the economy constant over different periods.
• households react through higher savings
• enable the future generation to pay higher taxes as well as keep aggregate demand in the economy constant over different periods.
• This theory assumes that the current generation pays tax less than the value of the current public services it receives, and thus saves. In our present federal situation this is not the case.
• In our present federal situation this is not the case.
• Households in developed States pay taxes that are not entirely used within the specific States compelling such States to borrow more or curtail current expenditure.
• compelling such States to borrow more or curtail current expenditure.
• Households in developing States pay taxes much less than the value of current expenditure and fill the gap by receiving higher financial transfers from the Union government.
#### High-income states: Tamil Nadu, Kerala, Karnataka, Maharashtra, Gujarat, and Haryana
#### Low income states: Bihar, Uttar Pradesh, Madhya Pradesh, Rajasthan, Odisha and Jharkhand as low-income States.
#### 14th FC period (2015-20):
#### ● Own tax revenue financed up to 59.3% of revenue expenditure in high-income States
#### ○ low-income States, their own tax revenue was financing only 35.9%.
#### ● The Revenue Expenditure to GSDP ratio for high-income States was 10.9%, which is lower than the similar ratio of 18.3% for low-income States.
#### ● High-income States curtailed their revenue expenditure and began financing a substantial part of it through their own tax revenues
#### ● Low-income States had higher Revenue Expenditure to GSDP and financed only a smaller portion of it through their own tax revenues.
#### ● Nearly 57.7% of revenue expenditure in low-income States was financed by Union financial transfers.
#### ○ Only 27.6% of revenue expenditure was financed by Union financial transfers in high-income States.
Aspects of federal finances:
• Low-income States finance a smaller portion of their revenue expenditure with their own tax revenue and also receive larger amounts of Union financial transfers.
• High-income States finance a substantial portion of their revenue expenditure with their own tax revenue but receive too little Union financial transfers.
• Deduce that the high-income States had to incur a deficit of 13.1%, and the low-income States ended up with a deficit of only 4% of revenue expenditure.
• High-income States raise higher amounts of their own tax revenue and curtail their own revenue expenditure They incur higher deficits because of lower Union financial transfers compared to low-income States.
• They incur higher deficits because of lower Union financial transfers compared to low-income States.
Fiscal behavior:
• The level of direct and indirect taxes people pay and expect an equivalent value of services from the government.
• Public services provided to the people of a State by both the State and the Union government should match this expectation.
• Any other fiscal behavior would result in burdening the high-income States with higher tax payments for both present and future generations.
• Intragenerational equity provides a larger unified market for everyone.
• Balancing both intragenerational and intergenerational equity is important, and it reiterates the need to balance equity and efficiency in the distribution formula for tax devolution to States.
Way Forward
• FCs use indicators such as per capita income, population, and area in the distribution formula. These indicators reflect the differences between States in terms of demand for public services (population and area) and the size of public revenue available (per capita income). These indicators carry a larger weight and assure equity in the distribution of Union financial transfers among States.
• These indicators reflect the differences between States in terms of demand for public services (population and area) and the size of public revenue available (per capita income).
• These indicators carry a larger weight and assure equity in the distribution of Union financial transfers among States.
• Variables such as tax effort and fiscal discipline carry smaller weight in the distribution formula to reward the fiscal efficiency of States.
• Equity variables are proxy variables, and they do not reflect the actual fiscal situations in States. The efficiency indicators are fiscal variables from the State budget.
• The efficiency indicators are fiscal variables from the State budget.
• The Union financial transfers make an impact only on the Budget and alter the fiscal behavior of States. It is appropriate to include more fiscal variables in the tax devolution criterion such that the Union financial transfers change the fiscal behavior of the States in the desired direction.
• It is appropriate to include more fiscal variables in the tax devolution criterion such that the Union financial transfers change the fiscal behavior of the States in the desired direction.
• Every State has a Fiscal Responsibility Act restricting the quantum of deficit and public debt. Reduced Union financial transfers to some States compel them to breach this legal limit. FC should assign a larger weight to fiscal indicators and incentivise tax effort and expenditure efficiency through larger Union financial transfers. This will automatically ensure intergenerational fiscal equity and sustainable debt management by States.
• Reduced Union financial transfers to some States compel them to breach this legal limit.
• FC should assign a larger weight to fiscal indicators and incentivise tax effort and expenditure efficiency through larger Union financial transfers.
• This will automatically ensure intergenerational fiscal equity and sustainable debt management by States.
QUESTION FOR PRACTICE
How far do you think cooperation, competition and confrontation have shaped the nature of federation in India ? Cite some recent examples to validate your answer.(UPSC 2020) (200 WORDS, 10 MARKS)